~ Investment Strategy

Morning Note 05/01/12

It seems to me that the outlook for risk assets is presently hard to predict. The economic outlook in Europe is not great and China is slowing, but those facts are not especially relevant because they are already in the market. Some observations of relevance might be:

Upside:

1. ECB action (though this may be less supportive than I thought — see below).
2. Improvement in US leading indicators.
3. Improvement in global PMI’s at the margin.

Downside:

1. European recession likely to be longer and worse than market anticipates — which will have a knock-on effect on debt ratios
2. US government spending may be mildly restrictive because of expiring provisions and Iraq troop drawdown.

There is also a clear downside risk in the form of the Chinese property slowdown. It is hard to predict how bad this will get.

The basis of my trading strategy is that I make trades when markets are predictable, and I do not make trades when they are not. At present it seems to me that the future movements of risk assets are not predictable, and so I am content to watch. I am reminded of the situation in mid-2010, when the market began to anticipate QE2. Accounts of the time often suggest that it was obvious that QE2 was on they way from Ben Bernanke’s Jackson Hole speech in late August, but in fact it was not obvious, to me and to many commentators, what the Fed was going to do or what effect it would have. I did not work out a view and go long the S&P 500 until 17th September, but I still made money on the trade, and the market continued its long upward pull for some months. My point is that, even if the market is presently predictable and I am just being slow to see it, that does not necessarily mean that I have missed a trade. One does not have to grasp watershed moments immediately to make money out of them.

I have had some more thoughts on the European situation and I think I now have it clearer in my mind. The fundamental problem in Europe is a set of internal balance of payments imbalances. These were not eliminated during the financial crisis because PIIGS governments continued to run deficits, thereby providing an injection into the economy that allowed imports to remain high relative to exports. Governments were funded, as usual, by the banks, which in turn were increasingly funded in the repo markets as market players preferred secured to unsecured lending as a result of their crisis experience. The economic problems of Ireland and Portugal, combined with Greece’s loose relationship with the truth, appear to have kicked off a vicious cycle whereby repo markets applied rising haircuts to these governments’ bonds, crimping the availability of funding for their banking systems and reducing the usefulness of such bonds, both of which led to a withdrawal of bank funding for Greece, Ireland and Portugal, which increased doubts about their ability to refinance maturing bonds, which meant rising repo haircuts, and so on. There ensued a balance-of-payments crisis in these countries as private capital ceased to flow into them. This crisis looked like a sovereign-debt crisis, because government deficits were the mechanism by which the balance-of-payments deficits were maintained. The immediate crisis was brought under control by a combination of intergovernmental loans and a portfolio rebalancing at the ECB in which lending to strong banks and sovereigns was dramatically reduced and lending to peripheral banks and sovereigns was dramatically increased.

Let us now turn to the most recent wave of the European crisis. In the latest episode, two countries that ought to be able to pay their debts eventually — Spain and Italy — saw spreads on their government bonds widen dramatically. This was likely the result of a vicious cycle in the repo market of the kind I describe above (visible in a sudden dash to German bunds in that market), as a result of a) insufficient action to tackle government deficits in these countries, b) the manifest unwillingness of European politicians to commit to resolving future balance-of-payments crises with intergovernmental loans on a scale that might be required by the two countries, c) the acceptance by European politicians of a partial Greek default and d) the fact that the ECB had sold pretty-much all of its holdings of core debt to buy peripheral debt and therefore could be of no further help as long as it was unwilling to expand its balance sheet.

Why has the crisis abated? It is because all four of the points above have been, to a greater or lesser extent, addressed. The governments of Spain and Italy have redoubled their efforts at austerity; European politicians have begun to put in place a set of rules to reassure core lenders about the ability of peripheral debtors to repay any future loans; and Angela Merkel appears to have ruled out “public-sector participation” in any future crisis waves, having understood that it does not help. All of these should reduce the haircuts applied to Spanish and Italian bonds and thereby increase private funding of the balance-of-payments deficits. Most important for putting an end to the vicious cycle, however, has been that the ECB has begun to expand its balance sheet aggressively, allowing it to continue to fund balance-of-payments deficits directly. This means that higher repo haircuts no longer translate into doubts about the ability of the Spanish and Italian governments to refinance their debt as it matures.

What will happen next? The basic problem remains the same as it has always been: someone has to fund peripheral balance-of-payments deficits until austerity has eliminated them, or else they will be eliminated by an economic collapse in the periphery. By starting to expand its balance sheet, the ECB has unambiguously assumed that role (effectively acting as central clearing counterparty for core banks’ lending to the periphery). If the ECB is prepared to expand its balance sheet indefinitely, then the crisis has been brought under control indefinitely. But it will not want to do that. Therefore, it will pull back from its lending and risk another increase in Spanish and Italian spreads whenever politicians stray from the path of austerity (in the periphery) or from the path towards the construction of a framework for further intergovernmental loans (in the core). That means it is quite possible that the ECB will instigate further crisis episodes. However, the trend will be for the ECB to continue to fund balance-of-payments deficits in the Eurozone while continued austerity depresses the European economy for as long as is needed to eliminate them — which could be many years.

This analysis has important implications for my market view. Although the ECB’s actions are clearly akin to QE, the fact that they are contingent upon austerity and thus upon economic weakness means that they are unlikely to lead to a sustained increase in European risk assets. Any banks that find themselves well capitalised and lacking in investment opportunities at home may direct their attention outside the Eurozone. However, the fact that European interest rates remain high relative to those in the US and Japan means that these banks are unlikely to fund any increase in their foreign lending in euros; thus a result of the current crisis may be the increased internationalisation of the stronger European banks — or they may simply retrench. Either way, the euro should not become negatively correlated with risk assets. Europe needs a weaker currency (an export boost would be helpful), but I doubt that it will get one by this mechanism. Of course, further interest-rate cuts from the ECB, which must be concerned about he continued high level of EURIBOR (which its crisis-lending measures pushed well below its policy rate during the financial crisis, but which has remained elevated during the euro crisis), would change the situation dramatically: Europe would look a little like Japan in the 2000’s, with a weak economy (albeit as a result of austerity rather than deflation) and continual monetary stimulus which would leak abroad.

On a final note, a Bloomberg story on gold this morning quoted an analyst as having uttered a tautology that I thought stood out even in the crowded field of useless market comment. Here it is: “There may be some people who prefer to hold cash and they sell as prices go up.” Would that I could aspire to such insight!

Data:

EZ CPI flash 2.8% a.e. Dec.
Factory orders 1.8% a.e. Nov.
Vehicle sales 13.6m a.e. Dec. Flat on last month. According to my model, this suggests PCE on durable goods will increase 0.14% in December, a significant slowing. However, it will still have had a strong quarter and its importance as a driver of GDP growth has faded in recent quarters.
Australia trade balance fell, d.e. Nov. Evidence of falling Chinese demand growth?
German retail sales -0.9% d.e. Nov.
Italian unemployment rose to 8.6%, d.e.
UK services PMI rose to 54, b.e.
Manufacturing PMI’s have shown a general improvement and expansion in developed markets ex. Europe.